Startup Venture Finance by Hartung Schroeder Law Firm

STARTUP VENTURE FINANCE AN INTRODUCTORY GUIDE

HARTUNG SCHROEDER LA W FIRM

NOTE: This Hartung Schroeder Practice Note has been provided for educational and informational purposes only. This Practice Note is not intended, nor should it be construed or relied upon, as legal advice. Your possession of this Practice Note does not create an attorney-client relationship between Hartung Schroeder and readers, and should not be substituted for legal advice in lieu of contacting an attorney in your state. Readers should consult an attorney regarding their circumstances and how the information relates to their circumstances. Reproduction of Hartung Schroeder content without written consent is prohibited.

INTRODUCTION Raising capital is vital to the survival and long-term success of startup companies, particularly those with the sorts of business models that tend to attract venture capital (VC) investment. These companies are often unprofitable and therefore need regular infusions of cash to continue funding their operations and growth. This is largely because many of these companies make the strategic choice to channel all of their resources into growing their businesses as quickly as possible to capture a dominant market share before focusing on profitability. All companies raising capital must decide which instrument to issue to their investors. For startups, the choice of instrument varies depending on the companyâ&#x20AC;&#x2122;s stage of development, investor base, and financial position. This Hartung Schroeder Practice Note provides an overview of: â&#x20AC;˘ The lifecycle of a typical startup, focusing on the type of startup that is a likely candidate for venture capital financing. â&#x20AC;˘ The types of financial instruments a typical startup issues to raise capital at each of the various stages of its lifecycle. This Practice Note assumes that the company raising capital is a startup organized as a Delaware C-corporation (as most venture-backed startups are). However, each of the instruments discussed may be adapted for a limited liability company to use. The Note also assumes that all of the instruments discussed are issued in private placements to accredited investors and not in offerings registered with the SEC.

CONTENTS 06

THE STARTUP LIFECYCLE • Naming Conventions

SEED FINANCING • Convertible Notes • Simple Agreements for Future Equity • Equity Seed Investments

INSTITUTIONAL VENTURE FINANCINGS • Series A Financings • Series A Terms • Series A Documents

SERIES B FINANCINGS AND BEYOND • Voting Thresholds • Board Composition • Protective Provisions • Represenations and Warranties • Founder and Early Employee Liquidity

BRIDGE FINANCINGS • Bridges of Necessity • Bridges of Choice

VENTURE DEBT

THE STARTUP LIFECYCLE The type of financing instrument that is the right fit for a given startup depends greatly on the company’s stage of development. Startups rarely exhibit a strictly linear progression as they grow (as there are inevitable twists and turns along the way). However, many startups generally attempt to follow a fairly well-defined path to success that includes the following stages: • Idea. All startups start with an idea. Prospective founders take that initial idea and begin to build on it, creating sketches, mockups, wireframes, and rough prototypes so that they can solicit feedback from trusted friends and advisers and potential customers. • Proof of concept. Next, the founders build a basic version of their product, often called a minimum viable product (MVP). The MVP has just enough functionality to allow the founders to test the market reaction to their product as cheaply as possible. • Building. If the concept is validated by the market, the founders raise sufficient capital

substantial version of the product to be released to a broader audience. • Scaling. Once the company has created a scalable version of its product, its focus shifts to expanding its customer base rapidly to capture as large a portion of the product’s addressable market as possible. • Maturity and exit. As the company matures, it turns its focus from maximizing revenue to attaining profitability. Often, however, startups are sold long before achieving profitability. Even many venture-backed companies that complete successful initial public offerings (IPOs) are not profitable at the time they go public.

to hire additional employees and build a more There are venture financing instruments that are tailored to meet the needs of a startup’s investors and founders at each of these stages of development.

NAMING CONVENTIONS Startups rarely follow a standardized capital raising progression. While a model startup may raise five successive rounds of financing labeled Series Seed, Series A, Series B, Series C, and Series D (with each round having the characteristics described in this Note), startups often label their financing rounds differently if they are concerned about the signal the name of their latest round sends to the market. The naming conventions for startup financing rounds are fluid in reality. For instance, consider a startup that raises a Series A round of financing, followed by two more rounds that are smaller than what the market often considers a proper Series B round should be. That startup may choose to label the last two rounds Series A-1 and Series A-2 (instead of Series B and Series C). Therefore, a more realistic startupâ&#x20AC;&#x2122;s financing rounds could be labeled as follows: Series Seed, Series A, Series A-1, Series A-2, Series B, Series C, Series C-1, Series D, and so on. This Note provides guidance on the market standards at each of the main stages in the startup lifecycle, but that guidance should not be viewed as prescriptive or exclusive. A startupâ&#x20AC;&#x2122;s capital raising history is often messy.

SEED FINANCING The first round of financing that a startup completes is commonly referred to as a seed round. If the investors are mostly close connections of the founders, this initial financing round may also be referred to as a friends and family round. Startups often close multiple seed rounds before they are in a position to complete a Series A round led by an institutional VC fund. A seed round typically occurs towards the end of

their own money (or small amounts of informally

the idea stage of a startupâ&#x20AC;&#x2122;s life. At the beginning

borrowed money from friends and family) to

of the idea stage, a prospective startupâ&#x20AC;&#x2122;s founders

develop their idea before raising an outside round

are often still employed full-time by a third party

of capital.

while working nights and weekends on their startup concept (a practice known as moonlighting). At

Sometimes a bootstrapped company can develop

this point, the founders are usually bootstrapping

the first testable version of its product (a so-called

the company. This means that they are spending

alpha version), or even a second version with

greater functionality (a beta version), before needing to raise a seed round of capital. Many founders, however, raise seed capital so that they can quit their day jobs and focus on their startups full-time, or, if they lack technical skills, hire contracted developers to create the first functional iterations of their concepts. The scale and structure of seed financings vary widely, but many share these characteristics: • Amount raised. Companies usually raise anywhere from $50,000 up to $1 million. Capital raises on the lower end of this range are sometimes referred to as “pre-seed” rounds. • Investors. Investors typically include family, friends,

high-net-worth

angel

investors,

or super-angel investors, which are angel investors who have become full-time investors in early-stage startups and who often create their own mini-VC funds allowing contacts in their personal networks to co-invest. • Instruments. Seed-stage companies generally issue convertible notes, simple agreements for future equity (SAFEs), or seed equity, usually in the form of convertible preferred stock (but occasionally using common stock).

CONVERTIBLE NOTES While convertible preferred stock is the most common venture financing tool for more mature startup companies, at the seed stage, the most frequently used instrument for raising modest amounts of capital is the convertible promissory note. Convertible promissory notes (or convertible notes, as they are more commonly called) are debt securities that have the following key terms: • Principal amounts that are due at a maturity date; • A fixed rate at which interest accrues on the principal balance; and, • A claim on the company’s assets that is senior to all equity holders and typically pari passu with all other unsecured non-senior debt. Although formally a debt instrument, many investors view convertible notes as deferred or unpriced equity in substance. The goal of their investment in the notes is to convert them into the same preferred equity security the company issues to its first institutional VC investor in the company’s Series A round, rather than to receive their principal plus interest at maturity. Therefore, investors typically view the conversion features discussed in this Section as the most important provisions in a convertible note deal, as they are the mechanisms by which the noteholders will eventually become stockholders of the company.

CONVERSION EVENTS

attractive than holding common stock alongside the founders.

Convertible notes convert into different types of equity when certain events occur: • Next

Equity

Financing

CONVERSION PRICE

conversion.

When a conversion event occurs, convertible

(referred

noteholders receive equity based on the principal

to as a Next Equity Financing) is the most

and interest balance of their promissory notes

common trigger for note conversion. In this

but at a price that is lower than the price paid

scenario, the principal and interest of each

by the new equity investors. The lower price the

note converts (at the relevant conversion

noteholders pay is calculated based on either a:

later

preferred

stock

financing

price) into shares of the same series of preferred stock that the new equity investor

• Discount rate. When notes convert at the

purchases in the subsequent financing round.

Next Equity Financing (usually the company’s Series A round), they convert at a per share

• Corporate Transaction conversion. If the

price that is less than the per share price of the

company is sold while the notes are still

preferred stock the company issues to its new

outstanding, noteholders may elect to have

investors in the equity financing. The rationale

their principal and accrued interest (or perhaps

for giving this discount is that the startup has

the interest plus some multiple of the principal)

typically “de-risked” to some extent since the

repaid; or convert the balance of their notes

noteholders made their original investment

into shares of common stock at a discount to

and, therefore, they should be compensated

the price at which the acquirer has offered to

for having shouldered additional risk early on.

purchase shares of the company’s common stock in connection with the sale transaction.

• Valuation cap. Most convertible notes also contain a ceiling, or cap, on the pre-money

• Maturity conversion. If the company reaches

valuation at which the notes may convert

the maturity date without having triggered a

in a Next Equity Financing to protect the

Next Equity Financing conversion or Corporate

noteholders against runaway valuations.

Transaction

conversion,

convertible

notes

often give investors the option to convert

When notes contain a discount and a valuation cap,

their notes into shares of common stock at

the price at which the notes convert is the lesser

a predetermined price or leave the notes

of the price calculated based on the discount and

outstanding.

the price implied by the valuation cap.

Investors rarely choose to convert to common

Convertible

notes

are

also

used

stock because continuing to hold debt of the

developed startups as bridge financing to a later-

company while leaving open the possibility of

stage equity round or a sale of the company. For

receiving preferred stock in a post-maturity

this reason, convertible notes are sometimes

Next Equity Financing is generally seen as more

referred to as bridge notes.

SIMPLE AGREEMENTS FOR FUTURE EQUITY The SAFE is a relatively recent addition to the seed financing toolkit, popularized by the premier startup accelerator Y Combinator. The SAFE has become an increasingly popular alternative to issuing convertible notes when a company is reluctant to issue debt for fear of reaching the maturity date before having concluded a Next Equity Financing. In this scenario, the founders generally negotiate an extension with the noteholders, who may try to extract better terms in exchange for their consent. The SAFE instrument was created to avoid this situation. The SAFE has all of the same conversion features of convertible notes but lacks the following hallmark debt features: • No maturity date. Until a conversion event occurs, the SAFE remains outstanding indefinitely. • No accruing interest. Investors receive only a right to convert the SAFE into equity at a lower price than the investors in the subsequent financing (based either on the discount or valuation cap in the SAFE).

A SAFE is otherwise substantially the same as a convertible note. It converts into stock on the same terms as a convertible note and using the same mechanics. Recently, seed investors have been increasingly willing to invest in SAFEs instead of convertible notes. This may be particularly true for “hot” startups, such as those that are admitted to Y Combinator’s accelerator program. 12

EQUITY SEED INVESTMENTS

When a startup chooses to raise seed capital by

COMMON STOCK

selling equity, it can issue shares of common stock or shares of preferred stock. Companies issuing

Common stock is the simplest form of equity

seed equity usually issue convertible preferred

investment. Investors who purchase shares of

stock, which is preferred stock that can be

common stock typically receive the same security

converted into shares of common stock (a hybrid

that

of the two share classes).

stockholders generally have the right to:

CONVERTIBLE PREFERRED STOCK

• Vote for the company’s board of directors and

the

startup’s

founders

hold.

Common

on other stockholder matters; While not as prevalent at the seed stage as in later rounds of financing, it is still somewhat common for seed investors (who are likely not institutional

• Receive dividends, if and when declared by the board; and, • Receive

their

proportional

the

VCs) to purchase convertible preferred stock. The

company’s remaining assets if the company is

security these investors receive is often designated

liquidated.

Series Seed Preferred Stock. However, they do not usually have additional Series Seed stock includes most of the same

rights, preferences, or privileges compared to the

rights, preferences, and privileges that are usually

founders.

included in Series A Preferred Stock, as well as the various contractual stockholder rights that are

Common stock is not the favored equity instrument

conventional in Series A financings (for an overview

for startup companies raising capital for several

of typical Series A financing terms, see Series A

reasons, including that:

Terms). However, to simplify the documents and with the understanding that seed investors are

• Investors who are purchasing equity, even

often not as sophisticated as institutional VCs,

at the seed stage, often want the rights,

Series Seed rounds often do not include some of

preferences, and privileges that preferred stock

the more mechanically cumbersome provisions

conventionally offers.

that are fairly standard in a Series A financing.

• Startups typically want to maximize their ability to use their common stock as equity incentives

For instance, Series Seed financing documents

to recruit and retain talent. When a company

often do not include some or all of the following

sells common stock to its outside investors,

terms:

this typically means that the common stock it issues to its employees under its stock plan

• Registration rights.

will have a higher valuation than it would have

• Rights of first refusal and co-sale.

had if the company had sold preferred stock

• Price-based anti-dilution provisions.

or convertible notes to its outside investors.

• Drag-along rights.

This can lead to the company’s options having

• Investor designees on the board of directors.

a higher strike price, making the options less attractive to early employees.

INSTITUTIONAL VENTURE FINANCING The absolute number of startup venture financings is greatest at the seed stage. However, most of the total dollar value of venture capital comes from institutional investors in companies that have already raised one or more rounds of seed capital. The institutional investors that serve as sources of

Not all of these investors fund startups at each

capital for startups typically include:

growth stage. For instance, hedge funds and mutual funds rarely invest in a startup’s Series A

• Venture capital funds;

round but are more likely to invest in later-stage

• In-house VC arms of large corporations;

companies that are close to launching an IPO.

• Growth-focused private equity funds;

Similarly, banks who offer venture debt typically

• Large corporations seeking to make strategic

only lend to startups that have already received

investments in high-growth businesses that

at least one round of institutional VC funding (see

may complement, or eventually disrupt, their

Venture Debt). The instruments that startups use to

existing lines of business;

raise capital from these institutional investors are

• Hedge funds or mutual funds; and,

somewhat more standardized than the instruments

• Venture debt lenders.

issued to investors at the seed stage.

SERIES A FINANCINGS For startups that have used the seed capital

• Investors. Series A investors include venture

they raised to build a product that allows them

capital funds focused on investing in early-

to demonstrate that their concept is viable and

stage companies and sometimes super-angels.

that an attractive market for the product exists,

• Instruments. Investors in VC-led Series A

the next step in their lifecycle usually involves

rounds purchase convertible preferred stock

raising a more substantial round of capital from

almost exclusively.

professional institutional investors (typically VC funds). This round of financing most often occurs

The terms of a Series A financing and the

when companies enter the building phase of

documents

growth. It is called the Series A round.

There has been a movement among VC firms to

used

are

largely

standardized.

embrace standard terms and documents to lower Series A financings typically have the following

transaction costs for venture financings. The goal

characteristics:

is to allow more of the investment proceeds to go toward building the business of the portfolio

• Amount raised. Companies usually raise between $3 million and $5 million.

company instead of immediately leaving the company in the form of fees.

SERIES A TERMS LIQUIDATION PREFERENCE

(or double-dip) feature. Participating preferred stock provides that the preferred stockholders

The terms of Series A Preferred Stock instruments

receive both the preferred liquidation preference

generally provide that, before any proceeds

from any sale proceeds and the preferred

from a sale or liquidation of the company can be

stockholders’ pro rata portion of the remaining

distributed to the holders of common stock, the

proceeds alongside the common stockholders

holders of Series A stock (and holders of Series

(sometimes up to a certain cap).

Seed stock, if the company issued preferred stock in its seed round) must first receive a liquidation preference

equal

the

original

DIVIDENDS

purchase

price of their preferred shares (known as a 1x

Special dividends are a hallmark of preferred

liquidation preference). If the proceeds from

stock in most contexts. Yet in Series A financings,

a liquidation or sale are great enough that the

many deals simply provide that the common

preferred stockholders would receive more than

stock cannot be paid a dividend unless the

their liquidation preference by converting their

preferred stock receives the same amount on a

preferred shares to common shares, they receive

per share basis. If the parties agree to include a

the greater amount.

preferred dividend, it is typically not a cumulative dividend and is only paid when and if declared by

It is uncommon in the current venture finance

the board of directors. Since startups are usually

climate for preferred stock to include a participation

losing money, and therefore do not have profits to 15

distribute to shareholders, startups rarely declare

average of the Series A price and the price being

dividends in any event.

offered in the subsequent down round.

CONVERSION

PROTECTIVE PROVISIONS

Shares of Series A Preferred Stock are convertible

Since Series A investors are almost always

into shares of common stock on a 1:1 basis

minority shareholders who also lack control of the

(subject to adjustment in case of certain dilutive

company’s board of directors, they usually receive

events) at the holder’s option at any time. In

negative control rights over certain actions. These

addition, the entire series of preferred stock

provisions typically require that the delineated

automatically converts into common stock if a

actions must receive approval from holders of a

certain percentage of the holders agree to convert

majority of the Series A shares before proceeding.

their preferred shares or the company completes

These veto rights generally cover critical company

an IPO. Sometimes, for this automatic conversion

actions that impact the economics of the Series A

to apply, the offering must be a Qualified IPO,

shares, such as:

meaning it meets certain negotiated minimum proceeds or offering price thresholds.

• Taking actions that adversely affect the rights, preferences, or privileges of the Series A

PRICE-BASED ANTI-DILUTION PROTECTION

Preferred Stock; • Amending

the

company’s

Most Series A investors negotiate to receive a

documents

(namely

the

downward adjustment to the purchase price

incorporation and bylaws);

organizational certificate

of their shares if the company later issues

• Issuing senior or pari passu securities.

common or preferred equity (or other securities

• Declaring or paying dividends;

convertible into equity) at a price below the Series

• Redeeming or repurchasing the company’s

A price (subject to exceptions for certain types of issuances). If a company does sell stock for less than the Series A price after the Series A round closes (known as a down round), the Series A conversion price adjusts to give the Series A

outstanding stock; • Increasing or decreasing the size of the company’s board of directors; and, • In some instances, selling the company or all of its assets.

investors more than one common share for each share of Series A preferred stock they hold, if and

BOARD MATTERS

when the Series A stock converts to common. This is known as a conversion price adjustment, and

The lead VC investor in a Series A round is typically

since the preferred stock of startup companies

entitled to one seat on the company’s board

generally votes on an as-converted to common

of directors (the Series A director). This leaves

stock basis, the conversion price adjustment

control of the board to the company’s founders

increases the economic value and voting power of

but allows the Series A director to be involved in

the preferred stock.

all important decisions. Since the Series A director does not control the board, Series A investors

The degree of the anti-dilution adjustment is

will sometimes require that certain important

usually calculated using a broad-based weighted

operational matters be approved by a majority of

the board including the Series A director. When the

CO-SALE RIGHTS

Series A investors do not have a representative on the board, they are usually allowed a non-voting

If the company and Series A holders do not

board observer.

exercise their rights of first refusal to purchase all of the shares on offer in a proposed transfer, the

REGISTRATION RIGHTS

Series A holders then have the right to sell some of their preferred shares proportionally alongside

Series A investors customarily receive demand,

the selling common stockholder on the same

piggyback, and shelf registration rights.

terms the common holder receives (also known as tagging along).

FINANCIAL

INFORMATION

AND

INSPECTION

RIGHTS

DRAG-ALONG RIGHTS

Larger Series A investors are usually contractually

Series A financing documents often include a drag-

entitled to receive certain financial information,

along (or bring-along) provision by which smaller

including

sometimes

stockholders of the company can be compelled to

monthly financial statements, as well as annual

agree to a sale of their shares if the majority of the

operating budgets and financial forecasts. They

common stockholders (usually the founders) and

are also given rights to inspect the companyâ&#x20AC;&#x2122;s

a majority-in-interest of the Series A investors are

books and facilities.

in favor of the sale. This prevents smaller investors

annual,

quarterly,

and

from exercising appraisal rights under Delaware RIGHTS OF FIRST OFFER

law or otherwise preventing or delaying a sale of the company.

Larger Series A investors typically receive a right of first offer (also known as a ROFO, preemptive

MANAGEMENT RIGHTS

right, or pro rata right) to purchase new securities offered by the company, allowing these investors

Due to certain Department of Labor regulations

to maintain their proportional ownership of the

under the Employee Retirement Income Security

company. This right is subject to exceptions for

Act of 1974 (ERISA), most institutional VCs require

certain issuances (the same types of issuances

their portfolio companies to provide a letter

that are excluded from price-based anti-dilution

granting their funds certain management rights,

protection).

including the right to consult with the board and management on issues of importance to the

RIGHTS OF FIRST REFUSAL

company.

Series A investors generally have the right to purchase the shares of larger common stockholders (such as the founders) when those stockholders seek to sell shares to a third party. The investorsâ&#x20AC;&#x2122; right of first refusal (ROFR) is secondary to a ROFR over those shares in favor of the company itself.

SERIES B FINANCINGS AND BEYOND Startups that have used the funds they raised in their Series A round to build scalable businesses generally continue to raise increasingly large amounts of capital as they focus on pursuing rapid growth. These later rounds of financing, occurring in the scaling phase of the company’s lifecycle, are typically named by progressing through the alphabet (Series B, Series C, and so on) for each subsequent round. These financings have the following characteristics: • Amount raised. The amount raised in these

to continue issuing convertible preferred stock

later stages ranges from $5 million to $10

with different terms that are layered on top of

million in a Series B round to upwards of $100

the existing Series A documents by amending

million in a Series E financing. These are rough

and restating them.

approximations, as the size of each round varies widely by company, industry, market cycle, and

In post-Series A financings, the negotiation generally

circumstance.

focuses on:

• Investors. In Series B and Series C rounds, the investors are predominantly VC funds and sometimes corporate strategic investors.

take certain actions.

In later-stage financings, VC funds often still

• Who will serve on the board of directors.

participate but are joined by growth private

• Which actions will require stockholder approval.

equity funds, and even mutual funds and hedge

• How

funds. • Instruments. Most of these later-stage investors

• Whose approval is required for the company to

much

company’s

coverage

and

representations

disclosure and

the

warranties

should require.

also purchase convertible preferred stock.

• Whether founders and early employees should

Once a company has issued Series A convertible

have an opportunity to sell a portion of their

preferred stock, it is generally most expedient

holdings.

VOTING THRESHOLDS

than early-stage investors on retaining enough control over the timing and nature of an exit event

In each subsequent round of financing a new lead

to ensure that they receive a minimum return on

investor typically joins the company’s investor

their investment. They often seek the ability to

base. This results in a multilateral negotiation

block any sale of the company that does not provide

between the new investor, the company’s existing

them with at least a 2x return on their investment,

investors, and the company itself regarding

for instance, even if the rest of the investors (who

whose consent will be required to approve or

invested at lower valuations) heavily favor the sale.

waive various matters. New investors often want to have series-specific veto rights (particularly

REPRESENTATIONS AND WARRANTIES

those that are purchasing enough stock to control an entire series of preferred stock), mainly over

As startups grow in complexity and scale, and as

issues where their interests may not be aligned

companies ask their investors to contribute more

with the earlier investors due to the higher price

substantial amounts of capital, the company

they are paying for their shares (such as waiving

representations and warranties in the SPA expand

antidilution adjustments). Existing investors are

in scope with each round (and with each new set

often reluctant to give new investors veto rights,

of lawyers reviewing the documents on behalf of

but if they are willing, they will then likely want

new lead investors).

similar rights for themselves.The company, for its part, would prefer that a majority of its investors

FOUNDER AND EARLY EMPLOYEE LIQUIDITY

rule the day, giving no single investor a veto over any matter.

Founders of startups often have little to no assets outside of their company’s stock and do

BOARD COMPOSITION

not typically pay themselves anywhere near the salaries that C-suite executives at comparable

In conjunction with the negotiation over voting

public companies earn. All of their personal wealth

rights, the investors and management typically

is concentrated in a single risky, illiquid asset. In

have to determine an appropriate composition for

an effort to diversify, many founders negotiate

the board of directors. In a Series B financing round,

to include secondary sales of their existing

a typical formulation is to provide that the common

shares as part of the offering to new investors.

stockholders appoint two seats, the investors

They sometimes give early employees and angel

appoint two seats (one for the Series A and one

investors an opportunity to participate in these

for the Series B), and those four directors appoint

secondary sales.

one mutually agreeable independent director. The board size grows in subsequent rounds of

As companies are going public much later than

financing and there is usually a new negotiation at

was common during the dot-com era, there

each stage about who should remain, who should

are often many rounds of private financing and

go, and the balance of power (in other words,

secondary sales of the type described above

whether the founders, the investors, or neither

before a company is ready to undertake an IPO.

group should control the board).

Indeed, most successful startups are sold before reaching that point.

PROTECTIVE PROVISIONS Later-stage investors (who typically invest at much higher valuations) are generally more focused

BRIDGE FINANCINGS Convertible notes are frequently used as bridge financing for companies that need additional capital before being able to close their next round of equity financing or sell the company. In this context, they are often referred to as bridge notes. Bridge notes are functionally the same as the

There are two basic scenarios in which a later-stage

convertible notes used at the seed stage. While

company will need to use convertible notes: when

they contain all of the same key provisions as seed-

the company is distressed and close to running out

stage convertible notes, the economic terms are

of capital; and when the company is performing

often substantially different, reflecting the later

well but could achieve a much higher valuation

stage and different circumstances in which bridge

from outside investors with a small infusion of

notes are most commonly used.

capital from insiders.

BRIDGES OF NECESSITY Bridge notes are often used in situations where

Distressed bridges or bridges of necessity are also

a startup has lost momentum and faltered to

sometimes accompanied by a restructuring of the

the point that, if it does not raise additional

company’s capitalization, in which the founders

capital immediately, the stockholders are left

and investors who refuse to continue supporting

with no alternative to winding up operations and

the company financially are heavily diluted or

liquidating the business.

lose their liquidation preferences, so that the investors providing the life support receive a

Companies in this predicament are typically not

disproportionate amount of the gain from any

able to raise a new round of outside capital and

potential future exit.

must instead rely on their existing investors to conduct an “inside round.” Those inside investors may be willing to provide additional capital if they think it will lead to something better than a total loss (usually they are aiming for some kind of fire sale of the business), but they expect particularly attractive terms given the high risk of failure. These terms may include: • Priority. By structuring distressed bridges as convertible notes, the principal of the notes is automatically senior in the liquidation waterfall to all equityholders. Bridge investors in a company that may well be on its way to ruin generally require that the last money in be the first money out if there is an exit. • Security. Investors in distressed bridges may consider securing the notes with the company’s assets if the company has sufficient assets to make the costs worthwhile. • Upside. If the bridge funds are sufficient to turn the company around enough to secure new outside financing, the bridge notes’ conversion discount to the price in the Next Equity Financing is typically steep (50% or greater). If the company uses the funds to arrange for a fire sale of the business, the bridge noteholders generally receive a multiple of their bridge investment back (perhaps, between 2x and 3x) before the equityholders receive any of the sale proceeds. 21

BRIDGES OF CHOICE Bridge

notes

are

also

sometimes

used

stronger

capital-raising

position

before

circumstances less dire than with bridges of

approaching new investors. In these cases, the

necessity. For example, consider a scenario where

terms of the bridge notes are often much more

a startup is doing well but is running low on cash.

similar to the terms of seed-stage convertible

With some extra time and a modest amount of

notes. In fact, they may be even more company-

capital, there is a good chance the company would

friendly, by only providing for a 20% discount

be able to hit an important operational or financial

with no valuation cap, for instance. Therefore, the

milestone, allowing it to raise additional outside

main features of convertible notes (whether at the

capital on attractive terms at a much higher

seed-stage or as bridge financing) remain largely

valuation. This would be better for everyone (the

the same, while the economic terms are highly

founders and the existing investors) as it would

context-dependent.

result in less dilution for them all. When a startup faces this situation, its existing investors may be perfectly happy to provide additional cash to help the company reach a

VENTURE DEBT Early-stage startups are rarely candidates for

available for a startup to borrow is dependent on

commercial bank loans unless the founders are

the health of their balance sheet at the time the

willing to give personal guarantees and have

loan is being disbursed.

sufficient personal assets to pledge as collateral. However, once a startup has institutional VC

The other big component of venture debt that

investors, there are certain banks that offer

helps banks get comfortable with the high risk

commercial lending services (such as Silicon Valley

profile of startup companies is the potential for

Bank, Square 1 Bank and Comerica Bank). These

significant upside. Companies receiving venture

venture banks look at VCs as potential backstops if

debt typically have to provide equity warrants

their venture-backed borrowers fall on hard times,

to the lender with a value equal to a certain

since VCs are often willing to invest additional

percentage of the principal balance of the debt

equity capital to keep their portfolio companies

(known as warrant coverage). This makes these

from going under.

venture banks something of a hybrid between traditional lenders and venture capitalists. Their

Still, from a bankâ&#x20AC;&#x2122;s perspective, lending to startups

goal is to more than make up for the additional

is a particularly risky business. As a result, most

losses due to the high startup failure rate with a

venture debt is structured as asset-based loans.

few homerun outcomes for startups in which they

This type of loan provides that the amount

have an equity stake through their warrants.

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